UNIT II.

FLEXIBLE BUDGETS

Contents:
2.0. Introduction
2.0. Learning objectives
2.1. Master Budget Versus Flexible Budget
2.2. Flexible budget preparation
2.3. Flexible budget approach for variance analysis
2.4 Chapter Summery
2.5 Answer Key for learning activity and check your progress questions

2.0. INTRODUCTION

We have learned in Chapter I that managers quantify their plans in the form of
budget and formal budgeting procedures result in comprehensive operational and
financial budgets for future periods. These budgets guide managers and
employees as they make their daily decisions and as they try to anticipate future
problems and opportunities. In this chapter we focuses on how managers use
flexible budgets as aids for planning and controlling. Recall that a key element of
control system is feedback –the comparison of actual performance with planned
performance. This chapter also provides an overview of how budgeting helps
performance evaluation.

This chapter will have three basic sections: master budget Vs flexible budget,
flexible budget preparation and use of flexible budget for variance analysis.

2.1. LEARNING OBJECTIVES

Upon a successful completion of this chapter, you should be able to:

 Distinguish between flexible budgets and master (static) budget

45
  Understand the performance evaluation relationship between master
(static) budgets and flexible budgets

 Prepare flexible budgets for planning and controlling purpose

 Use the flexible budget approach to compute sales volume variances and
flexible budget variances.

2.2 MASTER BUDGET (STATIC BUDGETS) VS FLEXIBLE BUDGET

2.2.1. A static budget

All master budgets discussed in the previous chapter are static or inflexible
because they assume fixed level of activity. By definition a static budget is not
adjusted or altered after it is drawn up, regardless of changes in volume, cost
drivers, or other conditions during the budget period.
period. In other words a static
budget prepared for only one activity level (for example one volume of sales
activity). Because static budgets depend on a particular level of activity, they are
not sufficiently informative when it comes to preparing performance report.

To illustrate suppose Evergreen Company prepares a budget based on detailed

expectation for the forthcoming month. Evergreen Company’s planned to produce
and sale 9,000 units. However, actual production and sales volume units turned
out to be only 7, 000 units instead of the original 9,000 units. A performance
report comparing the actual production costs and sales amount with the planned is
given in Exhibit 2-1.

Exhibit 2-1: Evergreen Company Performance Report

Particulars Actual Master Master (static)

46
 Budget
Budget
Variances
Units 7,000 units 9,000 units 2,000 units U
Sales Br. 217,000 Br. 279,000 Br. 62,000 U
Variable Expenses
* Manufacturing Br. 151,270 Br. 189,000 Br. 37,730 F
* Selling 5,000 5,400 400 F
* Administrative 2,000 1,800 200 U
Total Variable Expense Br. 158,270 Br. 196,200 Br. 37,930 F
Contribution Margin Br. 58,730 Br. 82,800 Br. 24,070 U
Fixed Expenses
* Manufacturing Br. 37,300 Br. 37,000 300 U
*Selling&Administrative 33,000 33,000 ---
Total Fixed Expenses Br. 70,300 Br. 70,000 300 U
OperatingIncome(Loss) Br. (11,570) Br. 12,800 Br. 24,370 U

N.B. Master budget variance (static budget variance) is the variance of actual
result from the master budget.

It is customary to label variances favorable (F) or unfavorable (U). The label

indicates whether the target or the actual figure is larger. The way in which labels
are applied depends on the item for which a variance is computed. If the item for
which the variance is computed is a revenue or profit item, favorable variances
are those for which actual is greater than the target; unfavorable variances are
those for which actual is less than the target (or the budget). If the item for which
the variance is computed is a cost or expense item, favorable variances are those
for which actual is less than the target. Therefore, if actual cost is greater than
target cost, the variance will be labeled unfavorable.

47
Now according to the report, unfavorable variance occurred for the operating
income. However, there is something fundamentally wrong with the report.
Actual unit level of 7000 units results are compared with a planned result for
9000units. Under normal circumstances we would expect lesser income at lower
activity level.

To create a meaningful performance report, actual revenues and costs and

expected revenues and costs must be compared at the same level of activity. Since
actual activity level often differs from planned activity level, some method is
needed to compare what the planned revenues and costs should have been for the
actual activity level. That is a flexible budget.

Flexible budgets,
budgets, which are budgets designed to direct management to areas of
actual financial performance that desire attention. Managers can apply this same
basic process to control important areas of performance such as quality or
customer service.

2.2.2 Flexible Budget (Dynamic Budget)

Actual activity may differ significantly from budgeted activity because of an

unexpected labor strike, cancellation of an order, an unexpected large new
production contract, and other factors. In contrast to the performance report based
only on comparing the master budget to the actual results, a more useful
benchmark for analysis is the flexible budget. A flexible budget (sometimes called
a variable budget) is budget that can easily be adjusted for differences in the level
of activity. It provides managers more useful information for planning and better
basis for comparing performance than, a static or fixed budget.

48
In performance evaluation, a master budget is kept fixed or static to serve as a
benchmark for evaluating performance. It shows revenues and costs at only the
originally planned levels of activity. However, a flexible budget will be prepared
at the actual activity level. The flexible budget is identical to the master budget in
format, but managers may prepare it for any level of activity.

2.2.3. Distinguishing Features of Flexible Budget

Flexible budgets have several desirable characteristics. They include:
i. Cover a range of activity
ii. Are dynamic
iii. Facilitate performance measurement.

Flexible Budget Cover a Range of Activity. Accurate predictions of activity

levels are sometimes hard to make, and many managers find they make more
effective decisions with the aid of flexible budgets. In other words flexible
budgets can help managers deal with uncertainty by allowing them to see the
expected outcomes for range of activity. It can be used to generate financial
results for a number of plausible scenarios.

Flexible Budget Are Dynamic. Flexible budgets allow managers to adjust plans
easily when activity level differs from the expected level. Such budgets address
“what is” rather than “what was” or “what was expected”. This dynamic nature of
flexible budget makes them a very useful decision making tool for management.

Flexible Budget Facilitate Performance Measurement. Measuring efficiency is

an important role of performance report. Fixed budgets are useful for measuring
effectiveness, i.e., achievement of goal. In some cases, however, fixed budgets do
not identify the question, “what should the result be, given the actual level of
activity”. In other words, the flexible-budget approach says, “Give me any
activity level you choose, and I’ll provide a budget tailored to that particular

49
level.” Whenever actual and budgeted activity is significantly different, a flexible
budget variance report provides a better measure of efficiency than a report based
on a fixed budget.

To summarize, flexible budget can be useful either before or after the

period in question. It can help managers choose a level of operations
(expected level of activity) and prepare the budget. It can also be helpful
at the end of the period when managers are trying to analyze actual
results.

Learning Activity-1
1. What is a static budget?
………………………………………………………………………………
………………………………………………………………………………
2. What is a flexible budget? Identify its major features?
………………………………………………………………………………
………………………………………………………………………………

2.3. FLEXIBLE BUDGETING PROCESS

The following steps are needed to develop a flexible budget.

i. Determine the range of activity the budget should cover (because cost
behavior patterns may be different in different ranges of activity)
ii. Determine the cost and revenue behavior pattern for each cost included in
the budget.
iii. Select the activity levels for which budgets will be prepared.
iv. Prepared a flexible budget using the cost behavior data and the selected
activity level.

50
Let’s prepare a flexible budget for the Evergreen Company, which is planning to
use a flexible budgeting system to plan and control its operations. Evergreen
made the following cost and revenue estimates for budgeting purposes:

Budget Formula Per Unit

Sales Br.
Br. 31.00
Variable Costs
* Manufacturing Br. 21.00
* Selling 0.60
* Administrative 0.20
Total Variable Costs Br. 21.80
Contribution Margin Br. 9.20
Budget Formula Per Month
Fixed Costs
* Manufacturing Br. 37,000
* Selling and administrative 33,000
Total fixed costs Br.
Br. 70,000

Instruction: Prepared a flexible budget for the next month using 7,000, 8,000,
and 9,000 units as activity level. Evergreen Company’s cost functions or flexible
budget formulas are believed to be valid within the range of 7,000 to 9,000 units.
At what level of activity does the company breakeven?
Exhibit 2.2 Evergreen Company Flexible Budget
Flexible Budgets For Various Activity Levels
7,000 units 8,000 units 9,000 units

51
Sales Br. 217,000 Br. 248,000 Br. 279,000
Variable Costs
* Manufacturing Br. 147,000 Br. 168,000 Br. 189,000
* Selling 4,200 4,800 5,400
* Administrative 1,400 1,600 1,800
Total Variable Costs Br. 152,600 Br. 174,400 Br. 196,200
Contribution margin Br. 64,400 Br. 73,600 Br. 82,800
Fixed costs
* Manufacturing Br. 37,000 Br. 37,000 Br. 37,000
*Selling and administrative 33,000 33,000 33,000
Total fixed costs Br. 70,000 Br. 70,000 Br. 70,000
Operating income (loss) Br. (5,600) Br. 3,600 B. 12,800

2.4. VARIANCE ANALYSIS-FLEXIBLE BUDGET APPROACH

Comparing the flexible budget to actual results accomplishes an important

performance evaluation purpose. There are basically two reasons why actual
results might not have confirmed to the master budget:

i. Sales and other cost-driver activities were not the same as originally
forecasted.
ii. Revenues or variable costs per unit and fixed costs per period were not as
expected.

Flexible Budget Variances: - the difference or variances between the flexible

budget and actual results for actual activity level achieved. This variance cannot
be due to activity levels and must be due to departure of actual costs or revenues
from flexible-budget formula amounts.

52
 Activity level variances: - (also known as Sales Volume Variance) is the
difference or variances between the master budget amount and the flexible budget
amounts. This difference is due to activity (sales) levels. Unit selling prices, unit
variable costs and fifed costs are held constant between the master budget and the
flexible budget for actual activity level.

The sum of the activity level variances and the flexible budget variances equal the
total of the master budget variances.

To illustrate, refer the data given in for Evergreen Company. Exhibit 2.3 shows a
condensed result of the static (master) budget variance, the sales activity variance,
and the flexible-budget variance.

Exhibit 2.3 Evergreen Company Summary of Performance

Flexible Sales
Actual Flexible Master
Budget Activity
Results Budget Budget
Variance Variances
Units 7,000 7,000 9,000 - 2,000 U
Sales Br. 217,000 Br. 217,000 Br. 279000 - Br. 62,000 U
Variable costs 196,
158,270 152,600 200 Br.5, 670 U 43,600 F
Contribution
margin Br. 58,730 Br. 64,400 Br. 82,800 Br. 5,670 U Br. 18,400 U
Fixed Costs 70,300 70,000 70,000 300 U -
Operating
Income (loss) Br. (11,570) Br. (5,600) Br. 12,800 Br.5, 970 U Br.18, 400 U

*U or F indicates whether the variances are unfavorable or favorable, respectively.

Total master budget variance (TMBV) = ALF + FBV

53
 Where TMBV = Total Master Budget Variance
ALF = Activity Level Variance
FBV = Flexible Budget Variance

Thus, the total master budget variance for Evergreen Co. amounts to Br. 24,370
unfavorable (Br. 5970 U + Br. 18400 U). The sum of the activity-level variances
here equals sales-activity variances because sales are the only activity used as a
cost driver.

Managers use comparisons between actual results, master budgets, and flexible
budgets to evaluate organizational performance. When evaluating performance, it
is useful to distinguish between effectiveness-the degrees to which a goal,
objective, or target is met- and efficiency-the degree to which inputs are used in
relation to a given level of outputs.

Performance may be effective, efficient, both, or neither. For example, Evergreen

Co. set a master budget objective of manufacturing and selling 9,000 units. Only
7,000 units were actually made and sold, however. Performance, as measured by
sales-activity variances, was ineffective because the sales objective was not met.

Was Evergreen’s performance efficient? Managers judge the degree of efficiency

by comparing actual outputs achieved (7,000 units) with actual inputs (such as the
quantity of direct materials and direct labor). The less input used to produce a
given output, the more efficient the operation. Evergreen was inefficient in its use
of a number of inputs. In the next Chapter, direct material, direct labor and
variable and fixed overhead flexible-budget variances will be discussed in detail.

Flexible-budget variances measure the efficiency of operations at the actual level

of activity. The flexible-budget variances shown in column (4) of Exhibit 2.3 total
Br. 5,970 unfavorable. The total flexible-budget variance arises from sales prices
received and the variable and fixed costs incurred. Evergreen Co. had no

54
difference between actual sales price and the flexible-budgeted sales price, so the
focus is on the differences between actual costs and flexible-budgeted costs at
actual 7,000-unit level of activity.

Sales-activity variances measure how effective managers have been in meeting

the planned sales objective. In Evergreen Co., sales activity fell 2,000 units short
of the planned level. The sales-activity variances (totaling Br. 18,400 U) are
unaffected by any changes in unit prices or variable costs. Why? Because the
same budgeted unit prices and variable costs are used in constructing both the
flexible and master budgets. Therefore, all unit prices and variable costs are held
constant in columns (2) and (3) of Exhibit 2.3.

Note that, in addition to the above, all variances are affected by the care used in
formulating credible budgeting or standard amounts.

In the next chapter will show how analysis uses standards to subdivide these
variances (flexible budget variance) into price and efficiency components.

55
Learning Activity-2
1. List out the steps for preparing flexible budget.
2. The following data pertains to X-company budget for April:
Selling price per unit…………………………Br. 180
Variable Costs per unit:
Direct Materials…………………………….. 60
Direct Labor ………………………………... 16
Factory overhead …………………………… 12
Marketing and administrative ……………… 11
Fixed costs:
Manufacturing ……………………………… 276,000
Marketing and administrative ……………… 434,000
Required:
a. Prepare a flexible budget for April, showing expected results at each of
three levels of volume: 10000 units, 12000 units and 14000 units.
b. Prepare a variance analysis table (as Exhibit 2.3) assuming the company
originally planned and has actual sales volume of 10000 units and actual
result as follows:
Sales …………………. Br. 1850000
Variable costs ………… 1120000
Fixed costs …………... 705,000

2.4 SUMMARY

The budget that provides a firm with a capability to compute expected revenues
and costs for range of activity is called a flexible budget. Flexible budgeting has
three major uses:

56
 It can be used to prepare the budget before the fact for the expected level of
activity
 Because flexible budgeting can determine what revenues and costs should be
at various levels of activity, the budget can be used after the fact to compute
what costs should have been for the actual level of activity. Once expected
costs are known for the actual level of activity, a performance report that
compares those expected revenues and costs to actual revenues and costs can
be prepared
 It can help the managers deal with uncertainty by allowing them to see the
expected outcomes for a range of activity.
Flexible budgeting is the key to providing the frequent feedback that managers
need to exercise control and effectively carry out the plans of an organization.
Variance analysis using flexible budget enables the managers to separate the
effects of sales volume from other explanations of why the static (master) budget
was not achieved. We have identified flexible budget variance and activity level
variance. The activity level variance measures the organizations effectiveness and
the flexible budget variance is often a measure of efficiency though it is also
affected by changes in prices and unit costs.

Check your progress question

1. Define flexible budget and how it differs from a static budget. What is the
deficiency of a static budget on performance analysis?
2. Zenit Plc. developed a new perfume called “virgin”. At the beginning of the
year, Zenit budgeted the following manufacturing costs based on production
of 100000 bottles of Virgin:
Direct materials ………….. Br. 400,000
Direct lab our……………. 230,000
Variable overhead ………. 310,000

57
 Fixed overhead………….. 440,000
Total manufacturing costs Br. 1,380,000
Demand for Virgin was disappointing and by the end of the year production had
been 75000 bottles. Actual costs were as follows:
Direct materials ………….. Br. 315,000
Direct lab our……………. 176,250
Variable overhead ………. 255,000
Fixed overhead………….. 400,000
Total manufacturing costs Br. 1,146,250

Required:
a. Prepare a performance report comparing actual costs with the flexible
budget amounts for actual production of 75000 bottles. Include column for
variances.
b. Prepare a flexible budget for production for the following levels of activity:
50000, 100000 and 150000 bottles of Virgin.

3. Budgeted overhead costs for two different levels of activity follow:

Direct labour hours
1000 2000
Maintenance Br. 10000 Br. 16000
Depreciation 5000 5000
Supervision 15000 15000
Supplies 1400 2,800
Power 750 1500
Others 8,100 8,200

58
Required:
Required: Prepare a flexible budget for an activity level of 1,650 direct labour
hours.
4. ZM transportation company executives have had trouble interpreting
performance for a number of years. The company has used a budget based on
detailed expectations for the forthcoming quarter. For example, the condensed
performance report for the recent quarter for a western branch was:
Budget Actual Variance
Revenue Br. 10,000,000 Br. 9,500,000 Br. 500,000 U
Fuel 1,000,000 986,000 14,000 F
Repairs& maintenance 100,000 98,000 2,000 F
Supplies 200,000 196,000 4,000 F
Variable payroll 5,700,000 5,500,000 200,000 F
Total variable costs 7,000,000 6,780,000 220,000 F
Supervision 200,000 200,000 ---
Rent 200,000 200,000 ---
Depreciation 1,600,000 1,600,000 ---
Other fixed costs 200,000 200,000 ---
Total fixed costs 2,200,000 2,200,000 ---
Total costs 9,200,000 8,980,000 220,000 F
Operating income Br. 800,000 Br,520,000 Br.280,000 U

Although the branch manager was upset about the unfavorable revenue variance,
he was happy that his cost performance was favorable; otherwise his operating
income would be even worse.

His immediate supervisor, the vice president for operations, was totally unhappy
and remarked: “I can see some merit in comparing actual performance with
budgeted performance with budgeted performance, because we can see whether

59
actual revenue coincided with our best guess for budget purposes. But I can’t see
how this performance report helps me evaluate the cost control performance of
the department head.”
Required:
a. Prepare flexible budget for ZM at revenue levels of Br. 9,000,000, Br.
10,000,000 and Br. 11,000,000.
b. Express the flexible budget for costs in formula form.
c. Prepare a condensed contribution –format income statement showing the
static (master) budget variance, the sales volume variance, and the flexible-
budget variance. Use the format used in the chapter.

2.5. ANSWER KEY TO LEARNING ACTIVITY QUESTIONS AND

CHECK YOUR PROGRESS QUESTIONS

Learning Activity –1
1. A static budget is a budget that does not adjusted or altered after it is drawn
up, regardless of changes in volume, cost drivers, or other conditions during
the budget period.
2. A flexible budget (sometimes called a variable budget) is budget that can
easily be adjusted for differences in the level of activity.
Flexible budgets have several desirable features. They include:
a. Cover a range of activity
b. Are dynamic
c. Facilitate performance measurement.
Learning activity –2:
1. 1. Determine the range of activity the budget should cover (because cost
behavior patterns may be different in different ranges of activity)

60
 2. Determine the cost and revenue behavior pattern for each cost included in
the budget.
3. Select the activity levels for which budgets will be prepared.
4. Prepared a flexible budget using the cost behavior data and the selected
activity level.
2. a.
Budget Flexible Budgets For Various Activity Levels
Per unit 10,000 units 12,000 units 14,000 units
Sales 180 Br. 1,800,000 Br. 2,160,000 Br. 2,520,000
Variable Costs
Direct material 60 Br. 600,000 Br. 720,000 Br. 840,000
Direct labour 16 160,000 192,000 224,000
Factory overhead 12 120,000 144,000 168,000
Marketing & Administrative 11 110,000 132,000 154,000
Total Variable Costs 99 Br. 990,000 Br. 1,188,000 Br. 1,386,000
Contribution margin 81 Br. 810,000 Br. 972,000 Br. 1,134,000
Fixed costs
* Manufacturing Br. 276,000 Br. 276,000 Br. 276,000
*Selling and
administrative 434,000 434,000 434,000
Total fixed costs Br. 710,000 Br. 710,000 Br. 710,000
Operating income (loss) Br. 100,000 Br. 262,000 Br. 424,000

61
 b.
Flexible Sales
Actual Flexible Master
Budget Activity
Results Budget Budget
Variance Variances
Units 10,000 10,000 12,000 - 2,000 U
Sales Br. 1850000 Br. 1800000 Br.2160000 50000F Br. 360000 U
Variable costs 1120000 990000 1188000 Br.130000U 198000 F
Contribution
margin Br. 730000 Br. 810000 Br. 972000 Br. 80000U Br. 162000U
Fixed Costs 705000 710,000 710,000 5000F -
Operating
Income (loss) Br.25000 Br. 100000 Br. 262000 Br.75000U Br.162000U

62